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International Trade Theory Chapter 2: The Law of Comparative Advantage. OUTLINE. 2.1 Introduction. 2.2 The Mercantilists ’ Views on Trade. 2.3 Trade Based on Absolute Advantage: Adam Smith. 2.4 Trade Based on Comparative Advantage: David Ricardo.
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International Trade Theory Chapter 2: The Law of Comparative Advantage
OUTLINE • 2.1 Introduction • 2.2 The Mercantilists’ Views on Trade • 2.3 Trade Based on Absolute Advantage: Adam Smith • 2.4 Trade Based on Comparative Advantage: David Ricardo • 2.5 Comparative Advantage and Opportunity Costs • 2.6 The Basis for the Gains from Trade Under Constant Costs • 2.7 Empirical Tests of the Ricardian Model
2.1 Introduction • Two Basic questions of international trade theory. (1) What is the basis for trade and what are the gains from trade? (2) What is the pattern of trade? • This chapter examines the development of trade theory from the mercantilists to Adam Smith, David Ricardo and Gottfried Haberler, and seeks to answer the basic questions.
2.2 The Mercantilists’ Views on Trade • The more gold and silver and a nation had, the richer and more powerful it was. • Thus the way for a nation to become rich is to export more than it imported. • The resulting export surplus would then be settled by an inflow of bullion or precious metals such as gold and silver. • Thus the mercantilists advocated restrictions on imports and incentives for exports.
2.2 The Mercantilists’ Views on Trade • A nation can gain in international trade only at the expense of other nations. • i.e., “Trade is a zero-sum game.” • Criticism: (1) The measure of the wealth of a nation? (2) Rulers vs. common people • Case Study 2-2 Mercantilism is Alive and Well in the Twenty-First Century
2.3 Trade Based on Absolute Advantage: Adam Smith • Adam Smith, The Wealth of Nations, 1776. • 2.3A. Absolute Advantage • When one nation is more efficient than (or has an absolute advantage over) another in the production of one commodity but is less efficient than (or has an absolute disadvantage with respect to) the other nation in producing a second commodity,
2.3 Trade Based on Absolute Advantage: Adam Smith • then both nations can gain by each specializing in the production of the commodity of its absolute advantage and exchanging part of its output with the other nation for the commodity of its absolute disadvantage. • Examples: • (1) Nations • (2) Individuals: • Thus, Adam Smith believed that all nations would gain from free trade and strongly advocated a policy of laissez-faire and free trade.
2.3 Trade Based on Absolute Advantage: Adam Smith • 2.3B. Illustration Table 2.1. The number of units produced by each hour of labor time • The U.S. is more efficient than (or has an absolute advantage over) the U.K. in the production of Wheat but is less efficient than (or has an absolute disadvantage with respect to) the U.K. in producing Cloth.
2.3 Trade Based on Absolute Advantage: Adam Smith • With trade, the U.S. would specialize in the production of wheat and exchange part of it for British cloth. • The opposite is true for the U.K. • If the U.S. exchanges 6W for 6C, the U.S. gains 2C or saves 1/2 hour of labor time. Similarly the U.K. also gains. (Explain!) • Note: Absolute advantage can explain only a very small part of world trade. Examples:
2.4 Trade Based on Comparative Advantage: David Ricardo • David Ricardo, Principles of Political Economy and Taxation, 1817. • 2.4A. The Law of Comparative Advantage • If one nation has an absolute disadvantage with respect to the other nation in the production of both commodities, the first nation should specialize in the production of and export the commodity in which its absolute disadvantage is small (this is the commodity of its comparative advantage) and import the commodity in which its absolute disadvantage is greater (this is the commodity of its comparative disadvantage).
2.4 Trade Based on Comparative Advantage: David Ricardo • Illustration: Table 2.2. The number of units produced by each hour of labor time • The U.S. is more efficient than (or has an absolute advantage over) the U.K. in the production of both commodities. • The U.K. is less efficient than (or has an absolute disadvantage over) the U.S. in the production of both commodities.
2.4 Trade Based on Comparative Advantage: David Ricardo • But the U.K. has a comparative advantage in cloth, and the U.S. has a comparative advantage in wheat. (Explain!) • With trade, the U.S. would specialize in the production of wheat and exchange part of it for British cloth. • The opposite is true for the U.K. • If the U.S. exchanges 6W for 6C, the U.S. gains 2C or saves 1/2 hour of labor time. Similarly the U.K. also gains. (Explain!)
2.4 Trade Based on Comparative Advantage: David Ricardo • 2.4B. The Gains from Trade • The relative prices before trade: U.S.: (Pw/Pc)us = 4/6 U.K.: (Pw/Pc)uk = 2/1 • If the U.S. exchanges 6W for 6C, the U.S. gains 2C or saves 1/2 hour of labor time. Similarly the U.K. also gains. (Explain!) • The U.S. would be indifferent to trade if it received 4C from the U.K. in exchange for 6W. The U.S. wouldn’t trade if it received less than 4C for 6W.
2.4 Trade Based on Comparative Advantage: David Ricardo • The U.K. would be indifferent to trade if it received 1W from the U.K. in exchange for 2C. The U.K. wouldn’t trade if it received less than 1W for 2C. • i.e., Both nations would gain from trade as long as the international relative price (terms of trade) is 4C < 6W < 12C (Pw/Pc)US < (Pw/Pc) < (Pw/Pc)UK 4/6 < (Pw/Pc) < 2/1 • If, for example, they trade 6W for 6C [(i.e., (Pw/Pc) = 1)], then both would gain. (Explain!) • Examples:
2.4 Trade Based on Comparative Advantage: David Ricardo • 2.4C. Exception to the Law of Comparative Advantage • When the absolute disadvantage that one nation has with respect to another nation is the same in both commodities. • Explain! • 2.4D. Comparative Advantage with Money (Skip)
2.5 Comparative Advantage and Opportunity Costs • Assumptions of the Ricardian Model • Only two nations and two goods • Free trade • Perfect mobility of labor within each nation but immobility between the two nations • Constant costs of production • No transportation costs • No technical change • The labor theory of value • While assumptions (1) through (6) can easily be relaxed, assumption (7) is not valid.
2.5 Comparative Advantage and Opportunity Costs • 2.5A. Comparative Advantage and the Labor Theory of Value • Labor theory of value: the value or price of a good depends exclusively on the amount of labor going into the production of the good. • Implications • Either labor is the only factor of production or labor is used in the same fixed proportion in the production of all goods. • Labor is homogeneous (i.e., of only one type).
2.5 Comparative Advantage and Opportunity Costs • Neither of these implications is true, and hence we cannot base the explanation of comparative advantage on the labor theory of value. • Use the opportunity cost theory to explain the comparative advantage. • 2.5B. The Opportunity Cost Theory - G. Herberler, The Theory of International Trade, 1936. - The opportunity cost theory: the cost of a good is the amount of a second good that must be given up to release just enough resources to produce one additional unit of the first good. - Examples:
2.5 Comparative Advantage and Opportunity Costs • 2.5C. The Production Possibility Frontier under Constant Costs • The production possibility frontier (or transformation curve) is a curve that shows the alternative combinations of the two goods that a nation can produce by fully utilizing all of its resources with the best technology available to it.
2.5 Comparative Advantage and Opportunity Costs • Table 2.4. Production Possibility Schedules for Wheat and Cloth in the U.S. and the U.K.
2.5 Comparative Advantage and Opportunity Costs • Figure 2.1. the Production Possibility Frontiers of the U.S. and the U.K.
2.5 Comparative Advantage and Opportunity Costs • Downward slope: If a nation wants to produce more of a good, it must give up some of the other good. • Straight line: Opportunity costs are constant. That is, for each additional 1W to be produced, the U.S. must give up (2/3)C and the U.K must give up 2C, no matter from which point on its production possibility frontier the nation starts.
2.5 Comparative Advantage and Opportunity Costs • 2.5D. Opportunity Costs and Relative Commodity Prices - The opportunity cost is given by the (absolute) slope of the production possibility frontier. - This is also called as the marginal rate of transformation. - Explain: (Pw/Pc)US = 4/6 = 2/3 (Pw/Pc)UK = 2/1 = 2 - Note that under constant costs, Pw/Pc is determined exclusively by production considerations in each nation.
Figure 2.2. The Gains from Trade 2.6 The Basis for and the Gains from Trade Under Constant Costs • 2.6A. Illustration of the Gains from Trade - Complete specialization
Figure 2.2. The Gains from Trade 2.6 The Basis for and the Gains from Trade Under Constant Costs • 2.6B. Relative Commodity Prices with Trade (Pw/Pc)US < (Pw/Pc) < (Pw/Pc)UK 4/6 < (Pw/Pc) < 2/1
2.7 Empirical Tests of the Ricardian Model • G. D. A. MacDougall (1951, 1952) - Labor productivity and export data for 25 industries in the U.S. and the U.K for the year 1937. • Hypothesis • Since wages were twice as high in the U.S. as in the U.K., costs of production would be lower in those industries where American labor was more than twice as productive as British labor. • These would be the industries in which the U.S. had a comparative advantage with respect to the U.K. and in which it would undersell the U.K in third markets.
2.7 Empirical Tests of the Ricardian Model • Figure 2.4. Relative Labor Productivities and Comparative Advantage – U.S. and U.K.
2.7 Empirical Tests of the Ricardian Model • Figure 2.4. Relative Labor Productivities and Comparative Advantage – Japan and Korea
2.7 Empirical Tests of the Ricardian Model • Case Study 2-4 Relative Unit Labor Costs and Relative Exports - U.S. and Japan
